The Fiscal Cliff can and will offer buying opportunities!

“The 1987 crash” “The Y2K bug” “The debt ceiling debacle of 2011” These events saw markets coming crashing down due to investor sentiments, but then turned out to be one of the best buying opportunities for stocks. As such we believe, the so called fiscal cliff may offer similar opportunities.

The first round of budget talks had been stated by the House Speaker as being constructive. Obama later on came out to express confidence that he and the Congress would reach an agreement that will avoid the automatic spending cuts and tax increases that are scheduled to occur at the end of the year. With these statements we saw a temporary rise in the equity markets towards the end of the trading period for the week, though last week’s trading sent the Dow Jones to its longest losing streak since August 2011. Investor sentiments remain weak, however it suggest hope for a rally once outcome of the budget talks are released.

The S&P has fallen by more than 5% since Obama’s re-election; however this pessimism is a result of investor’s sentiment rather than technicality. It doesn’t really sound right to wake up the day after an election and realize that the economy will suffer from a “fiscal cliff”. The phrase “fiscal cliff” is now part of the American lexicon, describing the looming deadline when tax cuts expire and spending cuts kick in at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron’s, over 1,000 government programs – including the defence budget and Medicare are in line for “deep, automatic cuts.”

In dealing with the fiscal cliff, U.S. lawmakers have a choice among three options; they can let the current policy scheduled for the beginning of 2013 – which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession – go into effect. The plus side: the deficit, as a percentage of GDP, would be cut in half.

They can cancel some or all of the scheduled tax increases and spending cuts, which would add to the deficit and increase the odds that the United States could face a crisis similar to that which is occurring in Europe. The flip side of this, of course, is that the United States’ debt will continue to grow.

They could take a middle course, opting for an approach that would address the budget issues to a limited extent, but that would have a more modest impact on growth.

None of this looks attractive!

The debate over how to solve the fiscal cliff may be more productive than is commonly recognized, as markets have considered all of the above. Hikes on capital gains and dividend taxes are on the line, and Obama has dug in his heels on what he sees as a mandate to make the tax code more progressive. He seems to have the upper hand in dealings with Congress because Republican lawmakers don’t want to see tax rates increase, which is what will happen if no solution is found by the beginning of 2013.

Republicans don’t want to take the blame for driving the economy over the cliff. The current crisis is similar to last year’s fight to raise the US debt ceiling, which led to the downgrade of the United States’ top credit rating in early August 2011. During the dealings, the S&P 500 lost 18.8% between its peak in July 2011 and its bottom in August. As the market slid, the political standoff badly hurt investors’ confidence in Washington, setting off a spike in volatility.

In the end a deal was announced that raised the ceiling and put off longer-term fiscal decisions until Jan 1, 2013, setting the stage for today’s “fiscal cliff” crisis.

After staying flat through September 2011, the S&P 500 jumped 31% between its October low and the end of March. The recent selling took the S&P 500’s relative strength index – a technical measure of internal strength – below 30 this week, indicating the benchmark is oversold and due for a rebound.

Volatility is expected to rise through the end of November and to spike in late December if no agreement on the fiscal cliff is reached in Congress. Alongside comes opportunity for those with high risk tolerance. However with both Obama and the Congress being happy with the first round of discussion we believe, markets are in for a yearend rally!